ELASTIC: In general, if changes in variable A cause changes in variable B, then the relative change in B is greater than the relative change in A. In other words, small changes in variable A cause relatively larger changes in variable B. An elastic relationship between two variables is a very responsive, or stretchable, relationship. You should compare elastic with inelastic.

The process in which banks increase the amount of funds in checkable deposits (and thus the M1 money supply) by using reserves to make loans. Money creation is made possible through fractional-reserve banking. Because banks keep only a fraction of deposits as reserves, extra reserves can be used to back up and create additional checkable deposits (money) that did not previously exist. Government policy makers (the Federal Reserve System) rely on the money creation process when conducting monetary policy. Money creation by banks is a modern alternative to printing paper currency.

The practice of fractional-reserve banking makes it possible for banks to create valuable money out of significantly less valuable inputs. The money creation process undertaken by banks is the modern alternative to printing valuable paper currency out of less valuable ink and paper. Banks use excess reserves to make loans and simultaneously to create checkable deposits, which then augments the money supply. This money creation process is controlled by the Federal Reserve System, and is the primary means of changing the total quantity of money in circulation and of implementing monetary policy.

The first thing to note about the money creation process is that money (M1) consists of two basic components--currency held by the nonbank public and checkable deposits. Money can be created either by creating currency or by creating checkable deposits. Printing paper currency is the "traditional" method of money creation. However, when it comes to monetary policy and controlling the money supply, the creation of checkable deposits is the more important of the two methods.

Fractional-Reserve Magic

Before getting to the nitty-gritty of money creation, an overview of fractional-reserve banking is in order. Fractional-reserve banking, the standard for modern banks, is the practice in which banks keep only a fraction of deposits in reserve. in this way, banks are able to keep deposits safe, while at the same time acting as profitable financial intermediaries.

Reserves are the assets (vault cash and Federal Reserve deposits) used by banks to conduct day-to-day transactions, especially processing checks or providing the "cash" needed for cash withdrawals. While prudently managed banks are inclined to keep reserves in the due course of business, bank regulators stipulate specific reserve requirements needed to back up deposits, usually in the neighborhood of 10 percent of outstanding deposits. Any reserves that banks have over and above those required by regulators are excess reserves.

Excess reserves are the key to money creation. Banks use excess reserves to make loans, a process that involves the creation of checkable deposits (and money). If banks obtain excess reserves, if they have more reserves than needed to keep deposits safe, then they make interest-paying, profit-generating loans. These loans find their way into the hands of the borrowers as checkable deposits.

Two Values: Use and Exchange

Money creation by the banking system might seem somewhat mystical and magical. With the stroke of a pen or the punch of a few computer keys, banks create a valuable item (money) seemingly out of thin air. To see how this is possible, consider two types of value--value in use and value in exchange.

Value in Use: This is the value of a commodity or asset based on the ability to satisfy wants and needs. A hot fudge sundae, for example, has value in use because a consumer like Edgar Millbottom obtains satisfaction from its consumption, from its use. The value of the hot fudge sundae depends on the satisfaction it generates.

Value in Exchange: This is the value of a commodity or asset based on the ability to trade for other valuable commodities or assets. An item need not provide for the direct satisfaction of wants and needs to have value in exchange so long as it can be traded for other items that DO provide satisfaction.

This difference is key to money and money creation. Money MUST have value in exchange. It must be tradeable for other items with value. However, money need NOT have value in use. It need not provide for the direct satisfaction of wants and needs. A $10 bill, for example, has very little value in use. Its value comes from exchange, from the ability to purchase other goods.

Value in exchange arises because everyone in the economy is willing to accept a given item as payment for goods with value in use. Such general acceptability (which is often guaranteed by government) is what enables an item to function as money. That is, in modern economies, the government of a nation officially stipulates which items are "legal tender." This official stipulation then gives money value in exchange.

This stipulation also makes if possible for the government to create money, which traditionally has been accomplished by printing paper bills or minting metal coins--the "print and mint" method. However, in modern economies, the money creation function also works through the banking system.

Making Money

So how does the money creation process work? The time has come to get down to the specifics.

Banks create checkable deposits (money) as part of the financial intermediary lending process. When banks make loans, funds are transferred to borrowers through checkable deposits. Using standard accounting practices, a loan involves the simultaneous creation of an asset on one side of the bank's balance sheet (the loan) and a liability on the other side (the checkable deposit).

Consider this hypothetical example of money creation--a monetary play in three acts.

Act I: The play opens with Edgar Millbottom, a footloose and fancy-free teenager, who stumbles upon a $100 bill while sauntering along the sidewalk en route to an afternoon of video games with his best friend, Chip Merthington. Having no immediate purchases to undertake with this new-found currency, Edgar deposits the $100 bill in his checking account at a local branch of OmniBank before reaching Chip's house. At this stage of the play, the amount of money does not change. Chip merely exchanges $100 worth of currency money for $100 worth of checkable deposits money.

Act II, Scene I: However, as the curtain opens on Act II, the introduction of this $100 cash deposit into the banking system triggers the money creation process. OmniBank has two key changes in its balance sheet. First, on the asset side, OmniBank has obtained an additional $100 of currency, which adds to the vault cash portion of reserves. Second, on the liability side, OmniBank has an additional $100 deposit that it is keeping safe for Edgar Millbottom.

Act II, Scene II: The key to the money creation process is the division of OmniBank's $100 worth of newfound reserves between required and excess. The extra $100 deposited into Edgar's checking account increases OmniBank's reserve requirements. For sake of argument, suppose that reserve requirements are set at 10 percent of deposits. In this case, OmniBank must keep an additional $10 of reserves to back up Edgar's $100 deposit. But OmniBank has an additional $100 of vault cash reserves, more than enough to satisfy reserve requirements. In fact, OmniBank has $90 worth of reserves over and above required reserves. It has $90 of excess reserves.

Act III, Scene I: What is OmniBank to do with this $90 of excess reserves in Act III? Because OmniBank generates revenue and profit as a financial intermediary, the logical course of action is to make a loan. As luck would have it, Pollyanna Pumpernickel, a hard-working, underpaid mother of two is in desperate need of a $90 loan to purchase a new fuel pump for her '84 Chevy. OmniBank is glad to help out (in return for a hefty interest payment, of course). And they have the excess reserves readily available to make this loan.

Act III, Scene II: But how does OmniBank transfer the borrowed funds to Pollyanna? They could pull four twenties and a ten from the vault, carefully counted over the counter by bank teller, Connie Constance. But more than likely, they will simply add $90 to Pollyanna's checking account. A few keystrokes on one of the bank's computer terminals will do the trick. Pollyanna then has an extra $90 of checkable deposits, $90 of extra money that she plans to spend on a new fuel pump for her '84 Chevy. This means that the economy also has an extra $90 of M1 money.

What has happened? By acting as a financial intermediary, OmniBank has used the excess reserves generated by Edgar's $100 deposit to create $90 of money, money that did not previously exist. OmniBank was able to undertake this miraculous feat through the magic of fractional-reserve banking.

A Magnified Change

The $90 of money that magically appears in Pollyanna's OmniBank account is only part of the money creation story. Additional money is created when Pollyanna writes a check on her Omnibank account to purchase the fuel pump needed for her '84 Chevy. Her expenditure triggers the creation of additional checkable deposits and money. The total amount of money created is a multiple of the $100 Edgar originally deposited in his OmniBank account.

Suppose, for example, that Pollyanna purchases her fuel pump from Palisades Autoparts. Palisades deposits Pollyanna's $90 check in its account at Penultimate National Bank. Once this check clears, Penultimate has an extra $90 of reserves and an extra $90 deposit in the checking account for Palisades Autoparts. But, it Penultimate needs only $9 of reserves to back up Palisades $90 deposit. Like OmniBank, Penultimate is likely to lend out this $81 of excess reserves.

This $81 loan is likely to trace a path similar to the $90 loan by OmniBank. The borrower, Quentin Quirkenstone, has $81 added to his checking account, which means $81 of money has been created. When Quentin spends this $81 check to purchase cubic zirconium engagement ring for his bride-to-be, the seller, Quillen Cousins Discount Jewelers, deposits this $81 check in its account at the Quicksilver Credit Union.

Once this $81 check clears, Quicksilver Credit Union ends up with an extra $81 of reserves and $81 of deposits. Because only $8.10 of the reserves are required to back up the $81 deposit, Quicksilver has $72.90 of excess reserves for lending, which leads to the creation of $72.90 of money.

This lending, spending, money creation process continues from bank to bank until the excess reserves are shrink to nothing. That is, the process continues until enough checkable deposits are created to transform all reserves into required reserves.

The total amount of checkable deposits created is then a multiple of the $100 of reserves received by OmniBank from Edgar's original deposit. In this simple example, the 10 percent reserve requirement means that $100 of reserves are used to back up $1,000 of checkable deposits. The amount of checkable deposits created is ten times the amount of reserves.

Creating Valuable Production

Perhaps money creation does not seem all that magical. After all, the primary function of the economy is to transform less valuable resources into more valuable goods and services. How does this differ from creating more valuable money from less valuable pieces of paper or electronic signals in a computer system?

The price of this delectable dessert, the value to the buyer, must be sufficient to cover the production cost of the inputs used.

The subsequent value of the hot fudge sundae is NOT created from NOTHING, it comes from SOMETHING, from the valuable resources. It the inputs used are more valuable, then the buyers must place a higher value on the hot fudge sundae, otherwise it will not be produced.

In contrast, the value of money created has almost no connection to the value of the inputs used. The government can print a $100 bill at about the same cost as a $1 bill. But the value is 100 times greater. The cost of the resources used by a bank to add $100,000 to a checking account are about the same as that of adding $1,000. But the value of the money created is 100 times greater.

This money creation process has precedents. One in particular comes from the mystical world of education. A college instructor has the ability to create a "B" from a "C" by adding a few points of extra credit to a student's total score. The result is a more valuable grade, which can be exchanged for such things as scholarships and better jobs. But what is the source of this value? Nothing more than the stroke of a pen or the tap of a few computer keys.

Monetary Policy

Government regulators, especially the Federal Reserve System (the Fed) controls the money creation process as a means of conducting monetary policy. Monetary policy is government manipulation of the money supply to stabilize the business cycle, reduce unemployment, and limit inflation. While the Fed could control the money supply through the print and mint method of controlling the quantity of currency in circulation, it prefers to control the money creation process undertaken by banks.

It does this primarily by controlling the amount of reserves banks have, but also by stipulating the amount of reserves banks are required to keep. In particular, the Fed controls bank reserves have through open market operations, which is the buying and selling of U.S. Treasury securities through what is termed the open market.

When the Fed buys in the open market, bank reserves increase. When the Fed sells in the open market, bank reserves decrease. With more or fewer reserves, banks make more or fewer loans and create more or fewer checkable deposits.

In effect, the Fed plants the seeds for money creation by changing reserves, then relies on banks being profit-seeking financial intermediaries to do the actual deed.

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